A put option (or “put”) is a derivative contract between a buyer and a seller. The put option allows the buyer of the option the right (but not the obligation) to sell shares of a security, such as a stock at a specified price, known as the strike price and at or before the scheduled date. On the other side of the contract is the seller who is obligated to buy the stock from the owner of the put at the agreed-upon price if the buyer decides to exercise their option.
By purchasing a put option, an investor is hedging that the price of the stock will decrease and is hoping to profit from that by purchasing the put option. In general, the more puts that exist for a stock (i.e. those with a high call option volume) is a bearish signal for that stock.
In this article, we’ll review put option volume along with some basic terminology surrounding put options. We’ll also go into detail about the options volume theory and discuss why call options volume is not a standalone indicator for successful trading.
How is a Derivative Contract Different from Direct Stock Ownership?
In most cases, trading stocks involves the direct ownership of shares. If an investor buys 50 shares of a company like Amazon (NASDAQ: AMZN), they immediately have those shares in their brokerage account.
That’s not the case with options trading. With options trading, traders buy and sell contracts called derivatives, in which they put up money that allows them, but does not obligate them, to buy or sell shares of a stock at a specific date and at a specific price.
Two of the most common derivatives contracts are call options and put options. With that in mind, it’s important to understand some of the key terminology that is part of options trading.
Key Terms to Help Better Understand Put Options
Strike price – this is the minimum price that the stock has to fall to for a buyer to consider picking up the option they purchased. The strike price for a put option is usually lower than the price at which the stock is currently trading. So for example, if an investor wants to buy a put option on AT&T stock that is trading at $31 per share, they may look for a put option with a strike price of $29. If AT&T’s stock falls to that level, the put option allows them to sell the shares at $27 (this is called putting the option on the buyer). Since an options contract on stock is equal to 100 shares, this would leave the trader with a $200 profit ($2 x 100). However, their actual profit will depend on the premium they had to pay for the option (see below).
Expiration date – this refers to the last date the option can be left open. On or before this date, the buyer of the option must exercise the option otherwise it is allowed to expire. The expiration date is fixed as the 3rd Friday in the month that the option is expiring. The seller of the put option is speculating that the contract will expire worthless, allowing them to collect the premium without having to buy shares.
Premium – this is the cost of the options contract (in this case a put option) to the buyer. Think of it like a transaction fee. The price of the premium is set based on the value of the underlying stock. As the stock price moves closer to being in the money, the premium goes up. The important thing to remember about a premium is that for the buyer of the option, this is the only capital that they are truly putting at risk in the event they decide not to exercise the option. If, using the example of AT&T stock, the premium for the put option was $1 it would cost the buyer $100 to purchase the option. Whether or not the buyer chooses to exercise the option the seller would collect the $100. However, if the buyer does exercise the option than the $100 has to be taken into account when considering how much profit the trader made. In our example, the trader made $200 from the difference in the stock price, but that cost would be reduced by $100 because of the premium.
In the money – a term used to describe a put option that would be worth more than $0 if sold on the open market. In our AT&T example, if the stock was purchased with a strike price of $29, the trade would be considered “in the money” as soon as the price fell to $28.99
At the money – a term used to describe a put option where the market price of the stock is the same as the strike price. In our example, that would mean the stock price was at $29.
Out of the money – this is a term that describes a put option where the market price of the stock rose above the strike price. In our example, this would mean that after purchasing the put option, the share price of AT&T stayed above $29. The buyer of the put option would simply allow the contract to expire “worthless” and they would only lose the premium that they paid for the call option. Put options that are out of the money are referred to as “otm put options”.
Bid-Ask Spread – this refers to the difference, expressed as a percentage, between the highest purchase price being offered for a security and the lowest offered sales price for the same security. A wide bid-ask spread usually indicates lower volume while a narrow spread usually indicates high volume. This is because as the bid/ask spread becomes narrower, the put option will be closer to being “in the money” and therefore more desirable.
What Do Changes in Put Option Volume Indicate?
Put option volume means the amount of buying or selling for a particular contract. It is usually similar to the volume of the underlying asset. However, volume is indifferent to the price direction of a stock. Volume only indicates to investors how actively an options contract is being traded. It is up to the investor to speculate on the price direction.
One way they can do this is to look at the put/call ratio. This indicates how many put options are being traded relative to call options as a percentage. When the put-to-call ratio is high it means that more put options are being traded relative to calls and signals that investor sentiment towards that stock is bearish.
Conversely, when the put-to-call ratio is low it means that more call options are being traded relative to puts and signals that investor sentiment is bullish. Put volume is specific to an options contract and not an indicator of what is going on in the broader stock market. Put volume can be high in both a bull market and a bear market.
What Implied Volatility Means to Put Option Volume
Implied volatility is the expected volatility of the underlying asset contained within the put option. Implied volatility effects the premium that the seller of the option is paid. When there is high put option volume, there is an expectation that the price of the asset will decline. This increases the level of implied volatility as the market expects that more traders will seek to buy the options.
Since the market is continuously adjusting the premium that a buyer will have to pay for the option, a high level of implied volatility increases the premium for the option. Implied volatility will decrease when demand for a put option is low. In response, the premium for the option will also decrease.
Implied volatility can be higher or lower depending on the option’s expiration date. For options with short-term expiration dates, the option will be less sensitive to implied volatility. However, longer-dated options are more sensitive to implied volatility because traders know there is a greater likelihood that the option will become “in the money”.
Do Put Option Volumes Accurately Predict Stock Price Movement?
The answer is sometimes, but certainly not always. Trading options based on volume assumes that the trading activity is being done by informed stock traders. It is risk neutral and can be highly competitive. A lot of options trading is done by hedge funds and other institutional investors. Buying or selling a put option is based on their fundamental and technical analysis regarding the price direction of the stock.
If the trader is anticipating good news about a stock, such as an earnings report that is expected to beat analysts’ expectations, then they will look to sell put options. Since the trader is anticipating that the share price will be increasing, they are hoping to find buyers that have a different opinion of the stock who will pay them a premium to buy their put option.
On the other hand, if the trader is anticipating bad news about a stock, they will look to buy put options to capitalize on the price movement.
In this way, options volume complements other trading signals. If there is a high put volume that is accompanied by a rising price for that put option it is a good sign that there is bearish sentiment surrounding the underlying asset. If there is high put volume that is accompanied by a declining put option price, it is a signal that there is speculation that the underlying asset will be increasing in price.
Some investors will look at technical indicators to help assign a context to a put option that has high volume. For example, if an option’s daily volume is breaking out of its moving average for a defined period of time (20-day, 50-day, 200-day, etc.) then that may indicate that the stock price is ready to make a big move in the trending direction.
The Final Word on Put Option Volume
Put options are a selling action based on speculation that the price of the underlying asset is going to decline. Like any investment strategy, price movement is only one factor for investors to consider when deciding whether to enter a specific options trade. The time to expiration and put option volume are also important.
Put option volume measures the amount of buying or selling for a particular put option. On any given trading day, there can be multiple puts and calls available for a stock. The ones that are trading most actively are the ones that can give traders both the price movement and volatility that they need to enter and exit option trades. When the put option volume is high, it means that traders are expecting price movement that will put the put option “in the money”. In contrast, when put option volume is light, it may mean the asset is not expected to move much in price. The put option volume along with other factors like implied volatility factor into the premium that a buyer pays to purchase a put option.
